Latest Bank of England QE move will help avert deflation ?

This week the Bank of England came out with a bold statement that has big ramifications for Londonâs bond markets, equities and the wider economy.

It promised to buy an extra Â£50bn in bonds as part of its quantitative easing plans to boost the money supply. This means it is now committed to buying Â£125bn in bonds â mostly gilts â or 20 per cent of the entire government bond market.

The aggressive move came as the markets were starting to question whether the QE project was losing momentum. After pledging to buy an initial Â£75bn in bonds in early March, gilt yields originally sank but have now risen back above levels before QE was launched. Ten-year gilts fell to a low of 2.91 per cent on March 13, but closed on Friday at 3.73 per cent.

The reason bond yields have risen sharply in the past two months is because investors have started to anticipate an economic recovery and risk appetite has returned. On the face of it, this suggests QE has not succeeded in its aims, although yields would have been much higher had the policy not been initiated.

The government is buying gilts in order to drive down yields, as these should bring down company borrowing costs, helping to stimulate the economy.

This is where QE has been more successful because corporate bond yields have fallen sharply in the past few weeks. Yields on triple-B sterling corporate bonds are half a percentage point lower than they were before QE. By buying bonds, the Bank is also increasing money in circulation, which should prompt more lending and boost activity in the economy.

The boldness of the Bankâs plan shows it is prepared to risk future inflation to prevent deflation today. Deflation would have far more damaging consequences for a highly indebted economy like the UK, bringing spending to a standstill and dramatically lowering living standards.

The Bankâs move looks like good news for equity investors as it will help boost sentiment and confidence.

However, improving conditions and more activity bring closer a dilemma over asset allocation. That is, at what point do government bonds offer more attractive returns than equities?

The current yield on the FTSE 100 is 4.8 per cent â a positive yield gap of 1 percentage point over 10-year gilts â providing equity investors with significantly better returns. But this may change by the end of the year.

HSBC forecasts that the dividend yield on the FTSE 100 will fall to 4 per cent by year-end as companies cut dividend payments. Government bond yields, on the other hand, could conceivably rise to 5 per cent, say analysts.

Indeed, equities are no longer as cheap as they were two months ago. The forward multiple on the FTSE 100 rose to 9.7 on Friday compared with 7 at the start of March while HSBCâs forecast for price earnings multiples on the FTSE 100 this year is 13.1 times compared with a historical average of 15.

Turning to the wider economy, the Bankâs move should certainly act as a big fillip as the policy action is far more aggressive than previous QE experiments, notably that of the Bank of Japan between 2001 and 2006. This was deemed a failure because of its timidity. The UK is unlikely to suffer a lost-decade to deflation like the Japanese.

However, short-term worries about growth and deflation may turn out to be the least of the marketâs problems. A bigger concern is the longer-term threat to the public finances, with the debt burden mounting ever higher.

Interest rate costs for the government have already risen to about Â£30bn a year because of rising gilt issuance, according to RBC Capital Markets. This could easily top Â£60bn in three yearsâ time, it says.

Such a scenario would present policymakers with huge challenges, particularly if spooked international investors began pulling out of sterling and sterling-denominated assets.

The Bankâs bravery will probably avert the disaster of deflation and may encourage equities to continue rallying. The problem of the public finances may be a harder nut to crack.